How Scenario Analysis Can Help Save Your Portfolio
by Charles Cheng, CFA – Clarity Investment Partners
鄭又銓, CFA -可承資本
As 2016 is winding down, we are reminded of past events with current or upcoming anniversaries which had profound impacts on global markets and on the world itself. The fifteenth anniversary of the September 11th World Trade Center attacks just passed, and the 10th anniversary of the subprime mortgage crisis and the 30th anniversary of Black Monday are fast approaching.
Figure 1: The Hong Kong Hang Seng Index fell 65.18% during the Global Financial Crisis
These three events, other than the turmoil that they caused, also had another thing in common- if they were readily predictable, they wouldn’t have happened in the first place. It has been an unusually long period of calm in the markets since the global financial crisis, almost ten years. It’s easy to become complacent after such a period. Historically, crises or “panic” have happened roughly every 6-8 years. While we are not predicting that anything will happen in the near term, it’s always better to go into an unexpected crisis prepared rather than deciding on a reaction after the fact.
For this purpose, we can utilize a simple tool called scenario analysis. Certain institutional investors use it to set limits for their portfolio exposures and individual investors can benefit from it as well.
Figure 2: The Taiwan Stock Exchange Index fell 47.85% during the October stock market crash 1987
The execution is simple. Take your current portfolio and then model its performance as if it was going through a repeat of these past crises. For funds and ETF’s you can just use the historical performance of various market indices and also account for the effects of any currency movements, if any. For large individual positions in companies, whether it is a stock or a corporate bond, there are several options.
First, if the company was actually listed at the time, you can take its percentage return during the crisis period. However, it may have been a very different company back then in terms of scale and even its major business lines. Instead, you can use a different company, which was of similar scale (large cap, mid cap, small cap), market sensitivity (denoted by “Beta”, something you can find for individual stocks on various financial information websites), and / or the same industry.
During crises, even quality companies with the most promising futures can fall precipitously. Even the stock of Apple, one of the best performing large companies of the last decade, fell roughly -60% from peak to trough during the global financial crisis.
The next step is to take those returns and apply it to your overall portfolio. Here is where it becomes more difficult. Calculate both the percentage return and dollar loss of each position, summing up to the loss for the entire portfolio. You can walk your portfolio through the historical time period week by week. Would you have bought more when a position has fallen 20%? What if it falls another 30% after that?
This exercise is even more valuable for positions that are leveraged or are based on financial derivatives (which can increase or decrease leverage based on how the security moves). In these cases, the effect on the portfolio and your state of mind as an investor may be hard to predict until you actually quantify it in dollar terms. Even worse, for margined securities, a loss beyond a certain level can trigger a margin call, which can lead to forced selling if an investor is unable to meet the margin requirements. An investor holding a 100% position in Apple stock in the beginning of 2008 at the peak of the financial crisis would have returned over 300% by September 2016. However, if he had held a 180% position in the holding (borrowing $80 for every $100 in cash), he would have been margin called within a month, being forced to put in more cash to maintain the position or sell at an 84% loss or worse.
Forced liquidations aside, at what point would you possibly call it quits and sell out, find it too painful to continue actively managing the portfolio? These are the kind of situation that we seek to avoid, because it may lead to permanent loss of value even if your investment selections turned out to be correct in the long run. Scenario analysis can lead you to anticipate these reactions and consequences before anything does happen and let you take action to avoid them. Of course, you may find that in going through these scenarios, you would have been perfectly comfortable sitting through all these events. Then perhaps the problem is that you may be taking too little risk in your portfolio and could possibly add more investment exposure. Whether it helped you avoid disaster or enabled you to invest more of your cash, an accurate assessment should help improve your investment performance over the long term.
As Mike Tyson used to say, “Everyone has a plan until they get punched in the face.” What scenario analysis does is simulate that punch and then lets you give yourself an honest assessment of how you would react if it had actually happened.
Mr. Cheng is a managing partner at Clarity Investment Partners, a Hong Kong based independent private investment office that directly manages personal accounts for families and institutions. www.clarityinvestment.com